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Can Greece hit its cost cutting targets?

Greece has signed up to a package of austerity measures designed to cut its deficit by 11 percentage points between 2009 and 2014, an aim that will deepen the recession and could spark a social backlash.

ATHENS — Greece has signed up to a package of austerity measures designed to cut its deficit by 11 percentage points between 2009 and 2014, an aim that will deepen the recession and could spark a social backlash.

The measures agreed this past weekend with the EU and IMF include more tax hikes and steeper cuts in wages and bonuses, in return for a record 110 billion euro ($146.5 billion (U.S.) bailout.

According to the aid plan, Greece will have to save an extra €30 billion on top of tough measures already taken but will take two years longer than initially planned to bring its budget deficit below 3 per cent of GDP.

Financial markets have reacted coolly to the bailout package, with investors concerned about its viability and the impact of further belt-tightening on an economy already in recession.

EU and IMF officials warned Greece would have to take more austerity steps if those already agreed are not enough to meet fiscal targets.

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Based on conversations with analysts and comparisons with other EU/IMF bailouts, here are three scenarios Greece faces, with implications for financial markets:

SCENARIO #1: Helped by the extra austerity measures and a successful crackdown on waste and tax evasion, the government manages to cut the deficit by 11 percentage points by 2014.

PROBABILITY: Low. Analysts say the new target to cut the deficit below 3 per cent in 2014 is more realistic than the previous 2012 target, but say risks are still high, with increasing public opposition and a bleak economic outlook the main dangers.

The additional austerity measures will hurt an economy already in the doldrums, pushing GDP down 4.0 per cent this year and by 2.6 per cent in 2011, according to the government. This would amount to Greece’s longest recession in 30 years. Deflation would complicate plans to keep debt levels steady between 2011 and 2013, and reduce them from 2014.

Public opposition to the measures has been rather muted so far but is on the rise and analysts say keeping public backing for three years of austerity will be tough as Greeks are prone to street protests and reluctant to pay taxes.

MARKET IMPLICATIONS: A deficit cut of 11 percentage points by 2014 would be a positive surprise for investors and make it easier for Greece to tap financial markets sooner.

SCENARIO #2: The economy shrinks more than expected or does not start growing again in 2012, with tax revenues collapsing and Greece widely missing its deficit targets.

PROBABILITY: Average. The chances of widely missing the targets will increase if the recession is deeper than the 4 per cent contraction forecast for this year or persists longer than forecast.

Social unrest could intensify if the unemployment rate pushes over 11 per cent and that could prevent Prime Minister George Papandreou’s government from pushing reforms. Labour unions have already vowed to resist further austerity.

Even without social unrest, cutting deficits in times of economic downturn is extremely difficult, as shown by the examples of three non-euro-zone EU states that pledged to trim public finance shortfalls as part of EU and IMF aid packages.

Latvia agreed with the IMF to aim for a fiscal deficit of 5 per cent of GDP last year but ended with almost double that after austerity measures exacerbated an economic contraction of 18 per cent that was more than three times worse than forecast.

IMF borrower Romania also saw its deficit rise from an original pledge of 4.6 per cent of GDP in 2009 to 8.3 per cent, and Hungary targeted a 2.9 per cent of GDP deficit, but finished at 4 per cent. All three had to renegotiate targets.

MARKET IMPLICATIONS: Political instability in Greece would strongly damage hopes of Greece managing its debt, increasing the prospects of a debt restructuring or default. This would raise pressure on Greece to withdraw from the euro zone, at least temporarily, and could undermine the credibility of the European single currency. It would also raise market pressure on euro zone periphery states like Portugal and Spain, potentially making it more expensive for them to borrow.

SCENARIO #3: Greece implements reforms but the new measures lead to a deeper recession that prevents the government from fully meeting its deficit-cutting targets.

PROBABILITY: High. The Greek public sector is in such disarray that even elementary spending and structural reforms could generate significant deficit cuts, despite the recession. The government has already legislated wage and pension cuts in the public sector of about €2.7 billion.

Defence spending cuts of €460 million are also underway. The government has capped pharmaceuticals prices by about €1 billion to limit hospital spending. The EU has pledged to speed up disbursement of an extra €1.4 billion earmarked for infrastructure.

But a deeper recession would mean higher unemployment and cast doubt on plans to save an additional €30 billion through public spending cuts and increased tax collection.

MARKET IMPLICATIONS: A slower than forecast deficit cut would not be a surprise but would create the impression that Greece has fallen short of its targets, possibly weighing on investor confidence and delaying the nation’s return to markets.

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